Doug Duncan Joins Bruce Norris on the Real Estate Radio Show #338

Norris Bruce

Bruce Norris is an active investor, hard money lender, and real estate educator with over 30 years experience. Bruce has been involved in over 2,000 real estate transactions as a buyer, seller, builder and money partner.

Norris Bruce
July 12, 2013
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Bruce Norris is joined once again this week by Doug Duncan. Doug is the senior vice president and chief economist for Fannie Mae. He is responsible for managing Fannie Mae’s economics and strategic research group. In this leadership role Duncan provides all economic housing and mortgage market forecast, analysis, and serves as the company’s thought leader internally and with the external constituent groups.

Shadow inventory has been a topic forever. It has probably changed definitions over the years, and a lot of people are absolutely adamant there is just going to be an avalanche of inventory that either banks have been hiding on the shelf or refused to foreclose on. Bruce asked Doug what his take was on all this. Doug said he keeps hearing the statements and reading the comments on the flood of bank REO. Doug thinks these types of stories are too strong a word; but if you look at the flow of data, you will see that there is a decline in seriously delinquent loans. The decline has been greater in states which have non-judicial foreclosure processes than those which have a judicial foreclosure process. In both cases, the level of seriously delinquent loans is still significantly higher than a normal level. What is not happening is a flood gate being opened and there being a flow of properties. It is a process that keeps grinding away, and the properties are coming to market.

There is a variety of reasons why it might take longer than people expect. In Florida, the problem is the pace of moving properties through the courts. If they were to suddenly hire 150 retired judges and put them all only on those issues, you might see a significant increase in the pace. Even there, all the legal hurdles have to be met before the properties can come to market. Doug just does not see this as a likely scenario. He does believe they will continue at the margins to add to the supply, but they just do not see a sudden swelling of properties.

Doug mentioned that delinquency is still quite a bit above normal, but a lot better than it was. Bruce asked if he had percentages for the worst where we were and where we are now. Doug said he did not, but one of the things Bruce wanted to mention was about somebody being delinquent, especially someone who has the capacity to make payment. When prices go up and make them whole, that is either going to result in someone making the payments current more often or at least in a sale that does not result in a loss. Doug said this was correct and that they talked at a different point about a good time to sell. If you are delinquent and underwater, but you suddenly discover that you might not be any longer underwater, that is going to change the incentive for you to bring the loan current. It may either allow you to dispose of the property with no loss or change your attitude about staying in the property. Even in 2001, 2002, and 2003, you always had delinquencies. However, they did not convert to losses just because prices were escalating.

We have had a pretty good year nationally as far as year-over-year price gain. In California we have had a ridiculous one, and now no sooner did we get off the mat than someone said we are in another bubble. Bruce wondered what Doug’s take was on the bubble talk. Doug said he just doesn’t see it, and he thinks the current pace of price appreciation is a function of non-supply. Builders are not building properties fast enough, and you are not seeing that flood of delinquent properties coming onto the market. You have seen some significant conversion of properties from the owner-occupied space to the rental space. He sees this tailing off some over the next couple years, but he certainly does not see this as a bubble. The one thing that some folks are worried about is whether the Fed has artificially driven up demand in some way through monetary policy. When they start to normalize, monetary policy may take some error out of the market. He does not necessarily see that because he does not see the supply phenomenon fixing itself in the near term.

When Doug talks about the Fed and their monetary policy, Bruce said he knows they have the short-term rates basically at 0. We just had an interest hike happen, and no one really changed anything other than verbally the sentiment of the future and an expectation that there might be less participation. Bruce asked what the Fed does to drive the interest rates down to where they were, and he wondered what is changing about this. Doug said he is absolutely right in that they have to target the rate at which banks lend to one another overnight at essentially 0. They held here for a long time, which is an encouragement for lenders to put money into the market. In addition to that, they had taken several actions that had been described as quantitative easing. This means they have gone into the market themselves and purchased assets from investors to put cash in the hands of those who can infuse it into the economy. Most recently they have been purchasing $85 billion monthly, made up of $45 billion of treasury securities and $40 billion of mortgage-backed securities. This too is intended to put down the pressure on rates, and this certainly has happened.

The first innovation of this was affected a couple years ago, so the subsequent eras have been less affected and have been partnered with the quality for investors. In Europe they have had a lot of fiscal problems, and investors have come to the U.S. market and have helped push interest rates down. A while ago when the minutes were released, the minutes revealed that the builders had discussed deciding how to end the program. However, they did not decide how to end it, but they simply discussed having to decide. This led to four days of instability just from the release of those minutes. They warned people that when it comes time for the Fed to actually devise a plan, even if they do not execute it, then you should expect more instability.

Chairman Bernanke simply discussed a plan a couple months ago that created quite a turn in the psychology of the market. No one changed any interest rates; they just talked about when they might not participate. It wasn’t even when, but simply there will be a day when they do not participate. The market probably over interpreted it, but they took this and Doug does not expect the Fed to go back and take it back. This represented a shift in sentiment among investors who suggest the Fed is going to start tightening credit. The way the government has talked about it is to reduce the amount of ease that they have in the market. This was also paired with some discussions of the European Central Bank and the Chinese with regard to their monetary posture. There was a sentiment among investors globally that the monetary ease across the globe is going to be in the not too distant future. People have started to adjust their investments and expectations accordingly.

Bruce asked what the total amount of mortgage-backed securities the Fed owns. Doug said they own about 22% of all the outstanding mortgage-backed securities, which he thinks is around $1.1 trillion. Doug spoke with the governors, and he said it felt more like an investor relations meeting than an update on the housing. Bruce asked what happens to the value of the mortgage-backed securities. He wondered what happens to their value when interest rates go up. Doug said the prices will fall. The Fed does not have to hedge what they have, and this is an important aspect of the market today that may be different from what you saw in 2003. The Fed rebates and earnings to the Treasury is not the same as a normal investor. Bruce also wondered if they rebate their losses as well. Doug said they will have to, but he does not think you will see them selling any of their securities out of their portfolio. He thinks they will amortize them over the life. They have been buying mid-term kinds of securities.

Bruce has been an investor since 1980, and when he decided he wanted to do it full-time he refinanced a house he owned free and clear at 17 ½% fixed. Ever since then, he managed to work his way down to an almost 3% mortgage rate. He really has been used to mortgage rates falling his entire investment career. Looking forward from where he started at 3%, the rate on a 30-year fixed rate was 2.84 right at the beginning of the year, and now it is at 3.86. Historically, 3.86 is still a great rate, but it still does not feel quite as good as 2.8. Bruce asked Doug what the trajectory is going to be, whether it is going to gradually go up for a long time or hit something normal and stay there. Doug said he believes it will be gradually up for a while. However, to look at where it will stop we need to see what would constitute normal in the mortgage space.

If you start at World War 2, and then you go forward and average the 30-year fixed mortgage across that time period, then what you have is a 6 ½% mortgage. To get to this in a normal time period, economists believe that the real burning asset to the real interest rates, not the inflationary interest rates, is over time at about 3%. You may get some variation around this depending on someone’s personal opinion. If you add 2% for inflation, which is the Fed target, then you are at 5% for an immediate term treasury. The spread for mortgages varies over time as well. If you take 150 basis points, that gets you to 6 ½% for a mortgage. It will probably be a while until we get there since the Fed has been very clear that they do not anticipate raising the Fed funds target until around the beginning of 2015. You still have a year and an half with a 0% Fed funds target. When they start to raise it, unless something unusual is happening in the economy, it is not going to go from 0 to 4 ½% with any great speed.

Some folks are thinking that normal, in terms of the Fed funds, started in the portfolio that we will not see until 2020. A lot can happen between 2013 and 2020. One of the things Bruce did in his own research was taking a look at how many changes the Fed had made every year since he started in the business. When he started in 1980, it was very volatile. The Fed changed rates 21 times during one of those years. What is interesting about the investor who has gotten involved in the last 3-4 years is the one thing that they are not used to, which is volatility. To his point he made earlier about the minutes the Fed introduced and the instability of the four days just from the release of the minutes, this is clearly a problem. In the last week we saw four Fed governors out speaking because of concerns related to the market’s response to the introduction of volatility. The Fed removed the volatility, so there is no way for markets to get back to normal without reintroducing that volatility. There are a lot of folks who do not have experience in managing in that environment.

The regarding the policies of Fannie Mae right now when it comes to lending, the maximum loan amount they have in the state of California is at $625 for a single-family property. We have been going up like crazy with the median price at a little over $400,000. Having a Fannie Mae loan amount at over 150% of median value historically has been unusual. This was a change that was made during the crisis, and there were a couple changes made to where the maximum loan size was $729,000. This was a temporary provision in the law that expired and dropped it back to 6.5. The changes were made because essentially the bulk of bank lending and private lending in the marketplace had frozen, at least on a broad-based volume basis. It was mainly FHA and the GSEs who were providing the liquidity to the market. Policy makers decided to try to provide a cushion for housing through that increase in the ceiling. There is no doubt that has been really vital. FHA has also become a big player because of their aggressive loan amount possible, and in Riverside a $500,000 loan is possible.

Bruce said last time he checked they were at about $350 median price going backwards. Typically when they had a $350 median price, they would only have $160,000 FHA loan. The FHA loan balance that is possible is way different. Bruce asked if it used to have a formula off of Fannie Mae’s maximum. Doug said there was, and they were also in the Legislation to allow them to choose. Their ceiling is still $729, which is above the Fannie and Freddie limit. When the determination is made on what to do with Fannie Mae and Freddie Mac in the policy world, one of the things that hopefully will simultaneously be evaluated will be the role of FHA. The theory on FHA has been that there are positive externalities to homeownership, and FHA is really a government-owned insurance program with 0% risk-adjusted rate of return targets. This typically meant a much lower maximum loan amount because of the positive externality in housing where there was a social purpose to allow lower income for folks at the lower end of the home price spectrum access to home ownership. $729 is probably not this number.

One of the biggest problems with all this is that it has been a big help, but it is also hard to retract. How do you say we are going to go back to the maximum loan amount of $200 rather than around $700. This is the very problem in how to make the adjustment. Most people believe that the more private markets provide as opposed to the government. However, once institutional arrangements become comfortable, it is very difficult politically to retract some of those changes. His guess is if it were going to be addressed, there would be some kind of a phasing process. Even that causes you certain kinds of disruptions. If the limit this year was $729,000, then next year it drops to $629,000, we have a segment of FHA loans in that $100,000 difference that now have little different life paths than a subsequent FHA loan.

Bruce asked what the general consensus is on the value of owning a home. We have Dodd-Frank that is about to be fully implemented, for example. Bruce wondered where the emphasis is. Are we only going to let people who really qualify own homes, let everybody in, or have something in the middle? Doug said subsequent to the crisis there has been a lot of rethinking about just how much emphasis to put behind homeownership from a policy perspective. This will come more into view as the discussion over what to do with the GSEs plays out. If you are going to introduce a higher level of private capital, the consumers are probably going to rise. This will bring back into focus the distribution of credit. Doug said we will not go back to where we were when people were using policy to get us to 72% homeownership. There will also be counter-pressure that disallows a policy that would drop homeownership rates to 58%.

In regards to qualified residential mortgage, Bruce asked if we have decided what the down payment will be. Doug said if you set the down payment at 20% with no gifts, you may have quite a different posture in the lending industry. In fairness, over the years in which automated underwriting tools were put into place, one of the things that was learned with that loan-to-value does proxy for other risk variables which we can now break out. There is a reason it does not have to be a 20% down for it to be a safe loan. That is still under discussion. Dodd-Frank has been in play for a while, but there is still arm wrestling going on. This is the 100th anniversary of the Federal Reserve. Its authorizing legislation was 37 pages, and Dodd-Frank was around 1300. We know the lawyers are doing well in Washington.